Groupon Risks A Discount By Waiting

The benefits to Groupon Inc. of raising an additional $950 million through a private sale of preferred stock instead of selling out to Google have been well publicized: growth capital, liquidity for management and early investors and a benchmark valuation from institutional investors, all without the complications of going public.

Reuters

But with the risks in Groupon’s business model, there is no guarantee that its valuation will inexorably rise. Its backers, which include Accel Partners, New Enterprise Associates and Digital Sky Technologies, may regret they didn’t take advantage of today’s valuations, via either a deal with Google or an IPO.

Chicago-based Groupon has a first-mover advantage in the business of group buying at the local level, with an estimated 80% of the market — always a powerful edge in the Internet sphere. The business model appears robust, with estimated revenues to date of up to $425 million, based on the company’s statement that it has saved customers $950 million, discounts of 50% to 90% and an assumed 50/50 revenue split in a shopping category with a current run rate reported to be $100 million in sales per month.

Demand looks healthy with 95% of Groupon’s 650 daily deals meeting minimum customer thresholds, and the company agrees to market only one of every eight vendor offerings pitched to it. It has also seen its subscriber base surge after Google’s highly publicized $6 billion offer for the company.

Groupon is taking advantage of the current environment, where investors seem willing to pay any price for financial exposure to pre-IPO Internet giants. But companies often benefit from being capital-constrained; when capital is too readily available, there is a risk of becoming capital inefficient. (The risk of Groupon being overcapitalized is mitigated by the fact that $344 million of the new funds will go to cash out board members and early investors.)

Before the latest round, Groupon was deploying capital to build out its network. It recently bought daily-deal sites in Northern California, Hong Kong, Singapore, the Philippines and Taiwan.

But the local advertising model poses inherent challenges when it comes to scaling, for the business requires an active sales force. The risk is that the business becomes a body shop rather than a technology platform. Groupon already has 3,000 employees, 50% more than Facebook.

By raising $950 million at a high valuation/low dilution, Groupon may discourage further investment in the roughly 500 other local-advertising Web businesses. But Google already has 4 million businesses using a local self-service model, Google Places, and has started a 100-person call center to compete for local advertising.

A deal with Google would have locked in gains for Groupon’s backers, but there were antitrust concerns that might have left the company in limbo for up to a year. In addition, with 10% to 40% of the $6 billion headline price consisting of earn-outs, the transaction was not as appealing as it appeared at first glance.

Google apparently had concerns about Groupon’s prospects. It’s not difficult to spot the issues. Most fundamentally, Groupon still must prove that it has a sustainable business model and is not just capitalizing on a fad.

The execution challenges cannot be minimized, either: Entering smaller domestic markets will be personnel-intensive; the core vendors on which it relies may choose to impose more restrictions on their own coupons; expansion may bring new vendors with lower-quality offers; Groupon is vulnerable to poor customer service from vendors that could discourage repeat purchasers; and a lack of exclusivity could limit Groupon customer loyalty.

Groupon is also investing in new platforms such as Groupon Stores, a self-service model in which vendors market their own group discounts via Groupon. However, the stores model has a gross margin as low as 10%, vs. the 50% on deals the company promotes.

Groupon’s decision to forgo an IPO adds to the stratospheric valuation as the limited supply of equity is overwhelmed by insatiable demand. However, management is taking on timing risk if the IPO market closes down or Groupon fails to live up to current lofty expectations.

Should Groupon’s growth trajectory flatten or margins fall, today’s lofty valuation could prove ephemeral. The transparency of an IPO could result in a lower market price and make the current funding seem like a costly miscalculation for the latest round of private investors.

(Peter Gallagher is a columnist with Dow Jones Investment Banker. Peter worked in research, sales and trading at Lehman Brothers and UBS as well as in corporate finance at Chase.)

Comments (1 of 1)

This article states the following:" The risk of Groupon being overcapitalized is mitigated by the fact that $344 million of the new funds will go to cash out board members and early investors.)" When investors are promised returns with other investors funds--is that not a Ponzi Scheme?

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